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A short note. Faisal Islam got his hands – literally – on the giants and titans. A fascinating quirk of British monetary history is the existence of £1m (“giants”) and £100m (“titans”) Bank of England notes, which are used as assets backing sterling banknotes issued privately by commercial banks in Scotland and Northern Ireland.

This post is a little premature, we need to wait for another month of labour market data, and the month 2 estimate of GDP. But the data seems likely to show that the UK has had around six quarters of fairly steady, fairly strong demand growth, averaging at least 4% NGDP growth from 2012 Q3 to 2013 Q4. Yet the level of market sector output per hour is likely to show almost no change at all over that period. This is starting to look like a total disaster for those of us hoping for at least some validation of the “endogenous aggregate supply” theory.

Chris Giles comments, as does Duncan Weldon. Duncan picks up a point which friend’o’the’blog James made in the comments here in a previous post: that average productivity is looking bad as low-productivity, low-waged workers regain employment, even if productivity might be rising for the rest of the workforce. Karl Smith makes a similar point at FT Alphaville. That’s all very reasonable, but this idea is giving in to supply-side pessimism. Supply-side optimists need to argue we have high-skilled, highly productive workforce part of which is merely sitting idle waiting for demand to return and put them back into work. But that does not appear to be happening.

It would be very interesting to see an update of the IFS analysis which showed where the loss of productivity has occurred in terms of movement of output/hour by sector and in the composition of hours between sectors.

I spent five minutes with the Labour Productivity data for 2013 Q3 and I get a feeling that I won’t like the answers. Here is a (perhaps) startling statistic: in the finance sector total hours worked is already back around the same level as 2008. Output per hour in that sector is down 12%. That hurts so, so much. Karl says, and he’s made the point before:

However, we should not forget that British productivity was supported by two very high margin wells which have begun to run dry, North Sea Oil and City of London Financial Services.

Replacing those sources of wealth will not be easy – but I add, it very likely will be done. Oil and Finance promoted a high priced pound and as a result made life difficult for other British exporters and life sweet for British importers. As that phenomenon turns around we should see a Britain that is increasingly self-sufficient and investing in technology and education to support the needs of its population rather than serving foreign demand for energy and complex derivatives.

Why does employment fall when there is a negative shock to aggregate demand? Because nominal wages are sticky. Why does employment rise when there is a positive shock to aggregate demand? Because nominal wages are sticky.

The phrase “cost of living crisis” is still stupid. Labour spent most of the last three years arguing that the government should be doing more aggressive demand stimulus. Well, guess what the effect of faster AD growth would be, Dear Eds? That’s right, an even faster rise in the “cost of living”. And because nominal wages are sticky that would mean even lower real wages… oh and hopefully, even higher employment. That is the point in doing demand stimulus.

That’s what Abenomics is trying to achieve in Japan, following bog standard New Keynesian macro policy for the ZLB. That’s what happened when FDR and Chamberlain left the gold standard in the 1930s, it raised “the cost of living.” The reason “Old New Keynesians” argue we need fiscal stimulus at the ZLB is to “create inflationary pressure” because you think you monetary policy can’t “get traction”. Yet the Two Eds are arguing UK has “too much inflationary pressure” even WITHOUT fiscal stimulus… so just what was the point of all those “too far, too fast” arguments? Why does anybody still take this garbage seriously?

And HM Treasury’s argument that we should look at real wages to see whether living standards are rising is just as stupid. Almost any available measure of real wages rose in 2009… so was that good for “hardworking people” (™ The Tory Party)? Only if you ignore the inconvenient fact that a million people discovered they were suddenly unable to work at all, whether “hard” or not.

This data is sufficient to demonstrate, in my view, that “living standards” are rising:

The UK inflation rate fell to 2.0% in December 2013. (!!!) This cannot pass without comment. What does this mean for UK macro policy? I will try to be consistent here. The two most important things about inflation are that:

a) Movement of inflation can represent supply-side or demand-side factors.

b) Macro policy is forward-looking; the inflation rate is backward-looking.

First, addressing (a). UK inflation is much lower than recent BoE forecasts; the February 2013 forecast expected the CPI to rise 3.1% in the year to 2013 Q4, the outturn is 2.1%. That’s a big miss! But real GDP is also much stronger than expected, and stronger by around the same magnitude. It’s likely we’ve seen at least 2%+ RGDP growth in the year to Q4, yet that February forecast was for 1.1% RGDP growth over the same period.

So this suggests either that the BoE is very bad at modelling the short run aggregate supply curve (which determines the split between inflation and output in the short run, given AD)… or that the curve shifted. I would say that both of these are somewhat true. The sharp rise in Sterling since mid-2013 is an obvious candidate for a supply shock, though it will have equal and opposite effects on different sectors.

(An obligatory dig at liquidity trappists on Sterling: nobody really believes that a central bank which is trying but failing to “create enough inflation” would stop printing money and then watch its currency appreciate by 10% over just nine months. The UK’s “liquidity trap” is a Very Serious Theory, in the Krugmanite sense of “Very Serious”.)

Moving on to (b). Does the current inflation rate tell us anything about whether monetary policy is too tight, looking forward? No, no, no. If you don’t answer “no, no, no” to that question, then you must also argue that the 5.2% inflation rate in September 2008 or September 2011 was telling us something useful about monetary policy at the time.

Relative to anything close to my ideal macro policy (say NGDPLT with a return to the 2009/10 trend), monetary policy is of course still much too tight. Relative to the actual goals of UK monetary policy I would be fairly relaxed about the outlook. The domestic equity market (FTSE 250) is rising 25-30% y/y. Inflation expectations are stable and consistent with hitting 2% inflation. I’d guess this is consistent with a continuation of 4-5% y/y NGDP growth. Those who thought running inflation 3.2% above target was not a sufficient reason for tightening monetary policy should also be relaxed about inflation going below target… or else admit that targeting inflation should not be a goal of macro policy in the first place.

No post is complete without a graph. It is interesting that there has been something of a decoupling of UK and US inflation expectations; the decline in the TIPS spread since early 2013 has not been matched by a decline in gilt market implied RPI. This stands in contrast to what happened to 2010 and 2011.

N.B. Yes, this graph compares apples (US expected CPI) with oranges (UK expected RPI), and the discontinuity in January 2013 caused by the RPI non-reform further distorts the validity of the UK data. But both countries have a 2% inflation target. Expected UK RPI of around 3-3.5% is consistent with expected UK CPI around 2%. And where’s that NGDP futures market?